201 lecture 01
TRANSCRIPT
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1.1
Lecture 1: FNCE20001 Business Finance
Introduction to Business Finance andFinancial Mathematics I
Sturla Lyngnes Fjesme
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Lecturers:
Dr. Sturla Fjesme (Lecture 1 - 12)
Dr. Vincent Grégoire (Lecture 13 - 24)
Tutor in Charge:
Robert Carey
Online tutor
Subject Administration
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Lecture 1 – 12
Lecture Date
Topic(s)
1 Tuesday, 29 July Introduction to Business Finance
Introduction to Financial Mathematics I
2 Thursday, 31 July Introduction to Financial Mathematics II
3 Tuesday, 5 August Valuation of Debt Securities
4 Thursday, 7 August Valuation of Equity Securities
5 Tuesday, 12 August Risk and Return
6 Thursday, 14 August Modern Portfolio Theory I
7 Tuesday, 19 August Modern Portfolio Theory II
8 Thursday, 21 August Modern Portfolio Theory III
9 Tuesday, 26 August Asset Pricing Models I
10 Thursday, 28 August Asset Pricing Models II
11 Tuesday, 2 September Asset Pricing Models III
12 Thursday, 4 September Capital Market Efficiency
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Lecture 13 - 24
13 Tuesday, 9 September Capital Budgeting I
14 Thursday, 11 September Capital Budgeting II
15 Tuesday, 16 September Mid Semester Exam
16 Thursday, 18 September Capital Budgeting III
17 Tuesday, 23 September Capital Budgeting IV18 Thursday, 25 September Debt, Dividends and Taxes I
29 September – 3 October Non-Teaching Period
19 Tuesday, 7 October Debt, Dividends and Taxes II
20 Thursday, 9 October Debt, Dividends and Taxes III21 Tuesday, 14 October Debt, Dividends and Taxes IV
22 Thursday, 16 October Guest Presenter (TBA)
23 Tuesday, 21 October Introduction to Derivative Securities I
24 Thursday, 23 October Introduction to Derivative Securities II
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Assessment 1 and 2: Two assignments which will count
towards 15% of your overall grade
Assessment 3: A mid semester exam which will count towards
25% of your overall grade
Date: Tuesday, 16 September
Time: During lecture time (must sit in the stream enrolled)
Venue: Wilson Hall
Exam duration: 60 minutes (no reading time)
Format: Multiple choice questions
Assessment 3: A two hour, end-of-semester final examination
which will count towards 60% of your overall grade
Subject Administration
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Subject Administration
All lecture notes and Tutorials are available on the subject’s
LMS page
Policy on calculators in examinations - see course outline
Required Textbook
Peirson, G., Brown, R., Easton, S., Howard, P. and Pinder, S.,
Business Finance, 11th
or 10th
ed., McGraw-Hill/Irwin (referredto as PBEHP)
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Code of Conduct During Lectures
Be attentive to the lecturer
Do not talk
Arrive on time and stay for the full lecture
Turn off mobile phones and other electronic devices
Bring required materials to the lecture
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Dr. Sturla Fjesme
PhD Financial Economics BI Norwegian Business School. Visiting Cornell University
Master of Science in Financial Economics with Honours BI Norwegian Business School
Bachelor of Commerce Bond University. Visiting Duke University
Previous Work Experience:
Deloitte
DnB NOR Bank
Royal Norwegian Air Force – Seargent
Current Position:
Senior Lecturer in Finance, University of Melbourne
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Subject Objectives
Solve basic problems in financial mathematics
Discuss the basic theories underlying the pricing of risky assets
Comprehend the concepts of portfolio formation and risk
diversification
Explain the fundamentals of capital budgeting, including the
use of alternative criteria, allowing for inflation and the
treatment of risk
Analyze the issues facing managers in capital structure and
dividend policy decisions
Use the features of financial derivatives to achieve specific
financial outcomes
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1. Introduction to Business Finance
1. Overview of the Finance discipline
2. Compare simple interest to compounded interest
3. Compute the future value of a single cash flow
4. Compute the present value of a single cash flow
5. Compute an unknown interest rate and time period
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Required Readings: Lectures 1 - 2
Lecture 1
PBEHP (10th or 11th ed.), Ch. 1 and Ch. 3 (sections 3.1 – 3.4.2)
Lecture 2
PBEHP (10th or 11th ed.), Ch. 3 (sections 3.4.3, 3.5 – 3.8)
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1.1 What is Finance?
Finance is the study of how individuals, businesses and
institutions acquire, spend and manage financial resources
Major areas of finance
Investment analysis and management
Corporate finance
Capital markets and financial institutions
International finance
Personal finance
Real estate finance
This subject provides an introduction to Investment Analysis
and Corporate Finance
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This Subject
Investment analysis is mainly concerned with where and how to
invest
Valuation of stocks, bonds and derivatives
Portfolio diversification
Asset pricing and market efficiency These topics (except derivatives) are covered in the first half of
this subject
Corporate finance is mainly concerned with the decisions of
managers Capital budgeting - what investments to make
Capital structure - how to finance these investments
Dividend policy - what to payout to shareholders
These topics (including derivatives) are covered in the second
half of this subject
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Career Opportunities in Finance
Career opportunities in several capacities
Financial management
Financial intermediaries
Securities markets
Government entities
Not-for-profit organizations
Personal financial planning
High demand for qualified finance specialists Finance specialists need a good working knowledge of other
disciplines as well
Economics, Accounting, Statistics, Mathematics, Marketing, …
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The Finance Function
The main goal of managers is to maximize the market value of
the firm
Value of the firm = Present value of future expected cash flows
This maximizes the wealth of shareholders
Shareholder wealth = Present value of shareholder’s future
expected cash flows
Do managers always maximize firm value?
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The Market Value of a Firm
Firm value is the present value of future expected cash flows
E (CF t ) = Expected cash flows received at the end of period t
n = Number of periods over which cash flows are received
r = Rate of return required by investors
( )
( )=1
=1
n
t
t
t
E CF Firm Value
r +∑
Main factors to consider when valuing a firm…
Magnitude of expected cash flows - E(CF t) Timing of cash flows - n
Risk of expected cash flows - r
Efficiency of capital markets
This is the main focus of Lectures 1 – 12
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Simple interest
The value of a cash flow is calculated without including anyaccrued interest to the principal
Example: If you invest $1,000 at 8% p.a. earning simple
interest for 5 years what amount will you have in your accountat the end of that time period?
Interest earned in each of the five years = 1000 × 0.08 = $80
Interest earned over five years = (1000 × 0.08) × 5 = $400
Future value at the end of year 5 = 1000 + 400 = $1,400
Future value at the end of year 5 = 1000(1 + 5 × 0.08) = $1,400
Future value using simple interest, F n = P0(1 + n × r )
Present value using simple interest, P0 = F n / (1 + n × r )
1.2 Simple Versus Compounded Interest
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Simple Versus Compounded Interest
Compound interest
Interest accrued is added to the principal and reinvested
The (future) value of a cash flow is calculated based on the
principal and interest accrued
Example: If you invest $1,000 at 8% p.a. earning compounded
interest for 5 years what amount will you have in your account
at the end of that time period?
Future value at the end of year 1 = 1000(1.08) = $1,080.00
Future value at the end of year 2 = 1080(1.08) = $1,166.40
Future value at the end of year 5 = 1000(1.08)5 = $1,469.33
Note that the difference of $69.33 (= 1469.33 – 1400.00) is due
to the compounding of interest (“interest on interest”)
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Simple Versus Compounded Interest
End of year Simple interest
Compounded
interest Difference
1 $1,080.00 $1,080.00 $0.00
2 $1,160.00 $1,166.40 $6.40
3 $1,240.00 $1,259.71 $19.71
4 $1,320.00 $1,360.49 $40.49
5 $1,400.00 $1,469.33 $69.33
20 $2,600.00 $4,660.96 $2,060.96
50 $5,000.00 $46,901.61 $41,901.61
100 $9,000.00 $2,199,761.26 $2,190,761.26
So what’s the big deal?
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The future value at r % p.a. of P0 today is the dollar value to
which it grows at the end of time period n
F n = P0(1 + r )n
P0
F n = P0(1 + r )n
0 n
Cash flows occur at the end of the period
1.3 Future Value of a Single Cash Flow
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Example: You decide to invest $1,000 for different time
periods. What is the future value of this $1,000 in 5, 20 and
100 years at an interest rate of (a) 6% and (b) 8%?
At r = 6% p.a.
F 5 = 1000 × (1.06)5 = $1,338.23
F 20 = 1000 × (1.06)20 = $3,207.14
F 100 = 1000 × (1.06)100 = $339,302.08
At r = 8% p.a.
F 5 = 1000 × (1.08)5 = $1,469.33
F 20 = 1000 × (1.08)20 = $4,660.96
F 100 = 1000 × (1.08)100 = $2,199,761.26
Future Value of a Single Cash Flow
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Future Value of a Single Cash Flow
Future Value of $1000 over Different Time Periods at Different Interest Rates
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
0 2 4 6 8 10 12 14 16 18 20
End of Year
F u t u r e V a l u e
4%
6%
8%
10%
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The present value (P0) at r % p.a. of F n at the end of time n is
the amount which invested today would grow to F n in time n
P0 = F n/(1 + r )n, or
P0 = F
n(1 + r )-n
P0 = F n/(1 + r )n
F n
0 n
Cash flows occur at the end of the period
1.4 Present Value of a Single Cash Flow
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Example: If you needed $10,000 in (a) five years and (b)
twenty years how much would you need to save and invest
today if the interest rates were (a) 6% and (b) 8%?
The present value today of $10,000 in five years
At 6% p.a.: P0 = 10000/(1.06)5 = $7,472.58
At 8% p.a.: P0 = 10000/(1.08)5 = $6,805.83
The present value today of $10,000 in twenty years
At 6% p.a.: P0
= 10000/(1.06)20 = $3,118.05
At 8% p.a.: P0 = 10000/(1.08)20 = $2,145.48
Present Value of a Single Cash Flow
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Present Value of a Single Cash Flow
Present Value of $10000 over Different Time Periods at Different Interest Rates
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
$10,000
0 2 4 6 8 10 12 14 16 18 20
$10,000 Received at the End of Year
P r e s e n t V a l u e
10%8%
6%
4%
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Factors Influencing Present and Future Values
The present and future values of a cash flow depend on the
following factors…
The time period, n
Future value increases as n increases
Present value decreases as n increases
The interest rate, r
Future value increases as r increases
Present value decreases as r increases
The method of computing interest (examined in lecture 2)
Future value increases as the compounding interval increases
Present value decreases as the compounding interval increases
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1.5 Unknown Interest Rate or Time Period
Example: You invest $10,000 for a five year period. What
interest rate do you need to earn for the funds to double in that
time period? If you invest $10,000 at an interest rate of 10%
p.a. how long will it take for these funds to triple in value?
In the first case we have an unknown interest rate, r
P0 = $10,000, F 5 = $20,000, n = 5
10000(1 + r )5 = 20000
So, (1 + r )5 = 20000/10000 = 2
r = 21/5 – 1 = 14.9%
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Unknown Interest Rate or Time Period
In the second case we have an unknown time period, n
P0 = $10,000, F n = $30,000, r = 10%
10000(1.10)n = 30000
So, (1.10)n
= 30000/10000 = 3.00 Taking natural logs we have…
n × ln(1.10) = ln(3.00)
So, n = 1.0986/0.0953 = 11.5 years
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Key Concepts
Managers should aim to maximize the value of the firm by
taking on profitable investments. This results in maximum
shareholder wealth
Money has time value because of compounded interest
In simple interest, the value of a cash flow is calculatedwithout including any accrued interest to the principal
In compounded interest, the value of a cash flow is calculated based on the principal and interest accrued
The present and future values of a cash flow depend on thetime period, the interest rate, and the method of computing
interest
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Formula Sheet
Future value of a single cash flow using simple interest
F n = P0(1 + n × r )
Present value of a single cash flow using simple interest
P0 = F
n / (1 + n × r )
Future value of a single cash flow
F n = P0(1 + r )n
Present value of a single cash flow
P0 = F n/(1 + r )n
P0 = F n(1 + r )-n
( Note: The formula sheets on the mid semester and final exams willcontain all the formulas covered in lectures but without the descriptions)